Agree Realty Corporation (NYSE:ADC) is trading with a trailing P/E of 22x, which is higher than the industry average of 20.1x. While this makes ADC appear like a stock to avoid or sell if you own it, you might change your mind after I explain the assumptions behind the P/E ratio. Today, I will break down what the P/E ratio is, how to interpret it and what to watch out for. View our latest analysis for Agree Realty
Breaking down the Price-Earnings ratio
P/E is often used for relative valuation since earnings power is a chief driver of investment value. It compares a stock’s price per share to the stock’s earnings per share. A more intuitive way of understanding the P/E ratio is to think of it as how much investors are paying for each dollar of the company’s earnings.
Price-Earnings Ratio = Price per share ÷ Earnings per share
P/E Calculation for ADC
Price per share = $45.06
Earnings per share = $2.044
∴ Price-Earnings Ratio = $45.06 ÷ $2.044 = 22x
On its own, the P/E ratio doesn’t tell you much; however, it becomes extremely useful when you compare it with other similar companies. Ideally, we want to compare the stock’s P/E ratio to the average of companies that have similar characteristics as ADC, such as size and country of operation. A common peer group is companies that exist in the same industry, which is what I use below. Since similar companies should technically have similar P/E ratios, we can very quickly come to some conclusions about the stock if the ratios differ.
ADC’s P/E of 22x is higher than its industry peers (20.1x), which implies that each dollar of ADC’s earnings is being overvalued by investors. Therefore, according to this analysis, ADC is an over-priced stock.
Assumptions to watch out for
While our conclusion might prompt you to sell your ADC shares immediately, there are two important assumptions you should be aware of. The first is that our peer group actually contains companies that are similar to ADC. If this isn’t the case, the difference in P/E could be due to some other factors. For example, if you inadvertently compared riskier firms with ADC, then investors would naturally value ADC at a higher price since it is a less risky investment. Similarly, if you accidentally compared lower growth firms with ADC, investors would also value ADC at a higher price since it is a higher growth investment. Both scenarios would explain why ADC has a higher P/E ratio than its peers. The second assumption that must hold true is that the stocks we are comparing ADC to are fairly valued by the market. If this does not hold, there is a possibility that ADC’s P/E is higher because firms in our peer group are being undervalued by the market.
What this means for you:
Since you may have already conducted your due diligence on ADC, the overvaluation of the stock may mean it is a good time to reduce your current holdings. But at the end of the day, keep in mind that relative valuation relies heavily on critical assumptions I’ve outlined above. Remember that basing your investment decision off one metric alone is certainly not sufficient. There are many things I have not taken into account in this article and the PE ratio is very one-dimensional. If you have not done so already, I urge you to complete your research by taking a look at the following:
- 1. Future Outlook: What are well-informed industry analysts predicting for ADC’s future growth? Take a look at our free research report of analyst consensus for ADC’s outlook.
- 2. Past Track Record: Has ADC been consistently performing well irrespective of the ups and downs in the market? Go into more detail in the past performance analysis and take a look at the free visual representations of ADC’s historicals for more clarity.
- 3. Other High-Performing Stocks: Are there other stocks that provide better prospects with proven track records? Explore our free list of these great stocks here.